Wednesday, February 17, 2010


Earlier this day, I came across Moody's Misery Index (link) which estimated the size of macroeconomic difficulties in European countries. In particular, European countries within and outside the Eurozone are likely to face stagnant GDP growth rates, high unemployment rates, deflationary pressures and a depressing fiscal outlook.

Moody's Sovereign Misery Index

Source: FT Alphaville (link)

The most problematic European countries seem to be the peripheral edge of the Europen Union - Greece, Spain, Portugal, Slovenia and Italy. Greece, Portugal and Slovenia are small economies without very much effect on the European GDP dynamics. However, the size of Spain's and Italy's economy is large enough to be able to exacerbate significant effect on GDP dynamics within the European Union and the Eurozone.

Debt-to-GDP ratio in selected countries

Source: Market Oracle (link)

Spain topped the Moody's Misery Index due to the highest estimated unemployment rate for 2010 and a whopping fiscal deficit. Where's the trouble? As I wrote earlier (link), prior to the outbreak of financial crisis, Spain had a favorable fiscal outlook in 2006 and 2007 and an unfavorable current account balance . In 2007, Spain experienced a 10 percent of the GDP current account deficit largely due to net capital inflows from surplus countries such as Germany and Netherands. These net capital inflows further inflated asset prices, causing an outburst of asset bubble. In the mean time, asset price inflation escalated and real estate price index soared. Government's remaining choice was to push for a fiscal surplus to avoid the inflationary shocks. When the bubble turned into burst, the shortage of external demand (in spite of favorable domestic consumption rate) caused the economy's overcapacity and a deeply negative output gap. In 2008, Spain's economy overheated and the output gap increased to historic highs (3.06 percent of potential GDP). In 2010, the estimated output gap is -2.12 percent of potential GDP. Due to weak aggregate demand - especially weak investment and external demand - asset and consumer prices are decreasing. As firms are reluctant to hire new labor, the result is high rate of unemployment, deflationary pressure and non-existent GDP growth. The macroeconomic situation in Spain pretty much reflects the general macro outlook for the entire Eurozone.

If the ECB decided to raise interest rates significantly, it would further depress an already weak investment activity. If ECB's interest rates decreased further, there would be a serious danger of deflationary trap which dragged the Japanese economy into a decade long period of deflation rates, zero-bound interest rates and stagnant economic recovery. As European population is aging rapidly (as in Japan and other industrialized nations), the outlook for the European economic recovery is rather timid.

Rapidly rising fiscal deficit (link) and public debt is a permanent threat to the stability of the Euro. Of course, the best possible cure to decrease the debt-to-GDP ratio is higher economic growth and also higher rate of inflation which decreases the stock of public debt through higher price level. Europe's real macroeconomic disease is not just low productivity growth and high tax burden but also very asymmetric economic policies. While the ECB sets interest rates for the entire Eurozone, Euroarea countries set independent fiscal policies. In addition, the appreciation of the euro hinders currency swaps into high-yield currencies. That could enable covered interest parity and the reinvestment of foreign currency back into Euro when its appreciation trend would reverse.

Asymmetric fiscal policies are likely to cause significant public debt concern if fiscal policies are discretionary. Prior to the emergence of economic crisis, half of the European countries ran discretionary deficit-financed fiscal policies. If European countries ran prudent fiscal policy based on low government spending and balanced budget, the asymmetric fiscal shocks weren't a major problem at all. However, strong public sector, high government spending and the lack of rule-based fiscal policies pose a significant concern for the stability of the Euro.

What I propose, is not the harmonization of fiscal policy but a strong committment of European countries to limit the scope of discretion in fiscal policy. Each country should forge a prudent fiscal policy without high fiscal deficit. In addition, countries should set a medium-term perspective of public debt reduction. That would ease the problem of asymmetric shocks during economic downturns and enhance the prospects of European single currency. In addition, European countries should rigorously liberalize labor markets. The liberalization of the labor market would remove the unneccesary wage adjustment rigidities. When wages are rigid downward - especially during the recession - higher wages exacerbate a significant pressure on unemployment. And when unemployment rate is high, the demand for discretionary fiscal policy and deficit spending is very high as well.

Without the necessary liberalization of labor market and the pursuit of prudent fiscal policies, the future of Euro and the prospects of the Eurozone are not bright at all.

Saturday, February 13, 2010


Source: IMF (2009)


Paul Krugman has blogged an interesting analysis of the anatomy of the recent economic crisis in Europe (link).

Europe's difficult macroeconomic situation in the aftermath of the financial and economic crisis has exacerbated rising fiscal deficits and public debt alongside strong deflationary pressures. These pressures were triggered by the highly negative output gap - the difference between the economy's potential output and the real output. In fact, a brief observation of the output gap estimates (link) shows that the sick men of Europe (Portugal, Greece, Spain, Italy, Slovenia) are likely to face negative output gaps. In 2010, Spain is likely to reach -2.12 percent output gap. Slovenia, Italy and Greece will also face a negative output gap. The negative output gap triggered strong deflationary pressures since the nominal aggregate demand is insufficient, causing a decreasing price level.

Before the financial and economic crisis of 2008/2009 evolved, Europe's peripheral economies faced strong asset price bubble. As real estate prices were soaring, these economies attracted significant capital inflows which lead to inflationary pressures. Before the crisis, the inflationary dynamics in the peripheral countries of the Eurozone were strong. In Greece, Spain and Slovenia, consumer prices increased by more than 3 percent on the annual basis. The asset bubble was further spread by low interest rates. The asset price inflation in these countries was very high. In Slovenia, five-year asset prices increased by 500 percent (see: IMF, International Financial Statistics). As the increase in asset prices widened, Europe's sick men were faced with rising current account deficit.

In 2007, Spain's current account deficit amounted to more than 10 percent of the GDP. In such circumstances, a clever monetary policymaker would push up interest rates. As interest rates were at historic lows during the pre-crisis period, the real cure was on behalf of the fiscal policy. Before the crisis, Spain's fiscal picture was very well indeed. From 2004 to 2007, Spain was running a fiscal surplus which reached the level of 2 percent of the GDP in 2006 and 2007. However, massive capital inflows were not sterilized by raising interest rates which further inflated the real estate bubble and overheating of Spain's economy.

Independent fiscal policies and a common monetary policy - which is an economic model of the EMU - cause asymmetric shocks. During the years of high growth, these shocks are mostly neglected. However, during the crisis these shocks might cause a serious trouble in the macroeconomic adjustment. Greece, which recently declared a worrisome possibility of debt default, is a typical case of what happens when asymmetric shocks persist.

As Greece, Spain, Italy, Portugal and Slovenia now face high fiscal deficits and poor economic growth, these countries will likely face years of deflationary pressures and high unemployment. The fiscal policymakers already exhausted the ability of governments to boost spending. Further growth of government spending is impossible unless European countries want the Greek debt episode to evolve in a domino effect throughout the Eurozone. The ECB will sooner or later this year raise the baseline interest rates to avoid the inflationary swings in Germany, Austria, Netherlands and other countries with current account surplus.

The macroeconomic outlook for the Eurozone is backlashed by the debt crisis in Mediterranean countries. An economic recovery may include indepedent monetary policies to adjust interest rates and prevent another asset bubble episode as well as to target current account balance. However, European countries will have to rethink the role of indepedent and discretionary fiscal policies pursued by the sick men of the Eurozone.

Friday, February 12, 2010



Paul De Grauwe published a very good article (link), discussing the macroeconomic origins of the current debt crisis in Greece.

"The period 1999-2009 has been organised in periods of booms and busts: the boom years were 1999-2001 and 2005-07; the bust years were 2002-04 and 2008-09.

One observes a number of remarkable patterns.

  • First, private debt increases much more than public debt throughout the whole period (compare the left hand axis with the right hand axis).
  • Second, during boom years private debt increases spectacularly.

The latest boom period of 2005-07 stands out with yearly additions to private debt amounting on average to 35 percentage points of GDP.

  • During these boom periods, public debt growth drops to 1 to 2 percentage points of GDP. The opposite occurs during bust years. Private debt growth slows down and public debt growth accelerates."


The Economist published a very lucid analysis (link) of the recent macroeconomic instability in the Euroarea, following the outbreak of Greek debt crisis (link) and disappointing quarterly data on GDP growth (link):

Barely had the ink dried on a statement by European leaders supporting Greece in its struggle to finance its debts when more bad news emerged from the euro zone. Figures released on Friday February 12th showed that GDP in the 16-country currency zone rose by just 0.1% in the three months to the end of December compared with the previous quarter. That there was any improvement at all was largely down to France, where a burst of consumer spending lifted the economy by 0.6%. In the region’s other big countries, GDP was either flat—as in Germany—or falling, as in Italy and Spain.